Hussman Weekly Market Comment: Unbalanced Risk

It's no secret that when Alan Greenspan stepped down from the Federal Reserve, I had hoped that Martin Feldstein would be chosen as Fed Chairman, instead of appointing Ben Bernanke to that role. In early 2008 (see Round Two - Home Price Erosion), while Bernanke was still downplaying mortgage risks, and the economy was already quietly in a recession that began nearly 6 months earlier, Feldstein was openly warning about housing and economic risks. He continued to advocate for proactive policies to blunt the oncoming damage, and criticized Bernanke's willingness to hit CTRL+P, saying "They've used up half their balance sheet setting up credit lines to take on questionable credits from the banks and the securities firms." Since then, the Fed has remained on exactly the same course, only with bigger numbers. This has encouraged needless speculation and sporadic bursts of pent-up demand, but has done nothing to address the underlying debt issues or the continued need for broad restructuring of bad credit both domestically and globally.

Notably, Feldstein is not just any Harvard economist, but is a member of the business cycle dating committee of the National Bureau of Economic Research (the official body that dates U.S. recessions), the president emeritus of the NBER, and the former head of the Council of Economic Advisors. In an interview last week on CNBC, Feldstein provided a good summary of present conditions:

"We are not doing very well. The economy is just coming along at a snail's pace. The first quarter numbers that we just got last week were not very good at all. The GDP number was 2.2%. That was a disappointment, but you know, it was all automobiles. 1.6 out of the 2.2 was motor vehicle production. So, people were catching up after not being able to buy them the year before. So, this is a very weak economy... I think the real danger is that this is a bubble in the stock market created by low long-term interest rates that the Fed has engineered. The danger is, like all bubbles, it bursts at some point. Remember, Ben Bernanke told us in the summer of 2010 that he was going to do QE2 and then ultimately they did Operation Twist. The purpose of that was to make long-term bonds less attractive so that investors would buy into the stock market. That would raise wealth and higher wealth would lead to more consumption. It helped in the fourth quarter of 2010 and maybe that is what is helping to drive consumption during the first quarter of this year. But the danger is you get a market that is not with the reality of what is happening in the economy, which is, as I said a moment ago, is really not very good at all."

In short, there is no question that at least on the surface, there is a lot of contradictory data available to support differing views about market valuation and economic prospects. However, once we make distinctions that have clearly been relevant in the historical data - normalizing earnings, recognizing the difference between leading, coincident and lagging indicators, weighting indicators based on their relationship to outcomes they purport to measure - much of the noise drops away, and we infer clearly negative risk for both stocks and the economy.

All of these conditions will change, and it's certain that our return/risk estimates will not remain in such an extreme condition for very long. Maybe our present concerns won't amount to as much downside as we expect. But if investors were to choose a point to test the hypothesis that this time will be different and risk will be well-rewarded, I hardly think a worse moment could be found.